Monday, November 23, 2009

In this report we describe the background to and the extent of the capital spending bubble in China and identify factors that will precipitate its deflation. We focus on Chinese capital spending firstly because it is the single most important driver of current Chinese and global growth expectations and, secondly and more importantly, investment-driven growth cycles tend to overshoot and end in a destructive way.

We conclude that the capital spending boom in China will not be sustained at current rates and that the chances of a hard landing are increasing. Given China’s importance to the thesis that emerging markets will lead the world economy out of its slump, we believe the coming slowdown in China has the potential to be a similar watershed event for world markets as the reversal of the US subprime and housing boom. The ramifications will be far-reaching across most asset classes, and will present major opportunities to exploit. There are three key reasons why we take this view:

China’s expansion cycle surpassing historical precedents: It is widely believed that China is still in an early development phase and therefore in a position to expand capital spending for years to come. However, both in its duration and intensity, China’s capital spending boom is now outstripping previous great transformation periods.

Policy actions not sustainable into 2010. This year’s burst in economic activity has been inflated by a front-loaded stimulus package and a surge in credit growth. Given their exceptional and forced nature we believe growth rates in government-driven lending and capital spending will collapse in 2010.

Overcapacity and falling marginal returns on investment: Analysis of industrial capacity, urbanisation and infrastructure development shows that China’s industrialisation and structural modernisation are largely complete. Combine this with falling returns on investment, and it becomes obvious that China’s long-term investment needs are grossly overestimated.

China’s Capital Spending in Uncharted WatersIn our view investors have underestimated both the maturity of the Chinese growth cycle as well as the degree to which recent growth is a direct extension of the global credit bubble. This bubble had two major manifestations. The first, which started unravelling globally in early 2007, was evident in excesses in real estate, consumption and private equity. The second manifestation, which has yet to fully deflate, was a boom in capital expenditure, led primarily byChina.

The Chinese economic “miracle”, referring to the past 30 years of growth at an average real rate of 10% can be broadly split into three periods. In the 1980s, the first stage was unleashed by modest reforms of Deng Xiapoing such as liberalisation of prices in the agricultural sector. After a brief pause coinciding with the Tiananmen events, the second stage concentrated on rationalization of labour that saw a proliferation of light industries at the expense of agriculture and State Owned Enterprises (SOEs). The third stage has been focused on expansion of heavy industries and infrastructure. What all three stages had in common was a central role of investments as a driver of economic growth. Indeed, China has emulated the path of other countries that have rapidly developed in the second half of the 20th century driven by high investment to GDP ratios (we focus on Gross Fixed Capital Formation, GFCF, which is a broad definition of investment). However, both in its duration and intensity, China’s capital spending boom is now outstripping previous great transformation periods (e.g. postwar Germany and Japan or South Korea in the 1980-90s, chart 1).

Credit Growth at Critical PointSimilarly to the housing and consumption bubbles in the Western economies, credit has played a pivotal role in the investment bubble in China. Since the beginning of the decade up to H1 2009, domestic credit in China has expanded 50% more than GDP (chart 5). China is an outlier compared to the other “BRIC” countries in terms of the credit to GDP ratio (140% as of H1 2009) and is already beyond the levels that historically have led to sharp and brief credit crises in the past (chart 6). If loans continue to grow at the current 35% rate, credit to GDP ratio will be close to 200% in China already in 2010, even with GDP expanding at 10%. This is a level similar to the pre-crisis Japan in 1991 and USA in 2008. All this points to that credit in China is not going to be able to grow for much longer without risking a major crisis.

Permanent Reduction in Capital Spending ActivityAs the dust settles, we believe China will enter a phase of permanently reduced capital spending activity, whereby consumption will become the upper boundary of growth. The deteriorating ICOR ratio discussed above clearly demonstrates that China is running out of easy ways to boost growth through investment. Below we have reviewed the three major destinations for capital spending in the recent years: manufacturing, real estate and infrastructure. Our analysis demonstrates that China is already a country with ample manufacturing capacity and an increasingly welldeveloped infrastructure, which does not support the notion of significant pent-up investment needs in China. Consequently further expansion will not have nearly as much impact on growth as in the past.

Consumption Growth Cannot “Replace” the Investment BoomIn the best-case scenario emphasised by China bulls, private consumption will smoothly overtake investment as the growth engine so that there is no pullback in the overall growth rates. Here, we will start with a very simple fact that private consumption in China accounts for about a third of GDP. As we discussed previously, after a bumper year for credit and investment activity, it is going to be hard for investments to continue growing at 30% in 2010. Even if we assume optimistic investment growth rates of 10% for 2010 and 0% for 2011, leaving the trade balance where it is now, private consumption would have to grow at an average real rate of 20-30% for the next two years for overall GDP real growth levels to hit the magic 10%.

Chinese Investment Slowdown a Global Market EventConsidering China’s role as a trailblazer and locomotive for the current global recovery efforts, any signs of a Chinese slowdown would have significant global consequences. Not only would it challenge the notion of emerging markets leading the world economy out of its slump, but it would also raise doubts over the sustainability and effectiveness of the various stimulus efforts under way in other countries.

Given the stakes involved, we can expect the Chinese as well as other governments to introduce further stimulus measures as signs of weakness appear. This may prolong the top, but as discussed in the report, China has reached an impasse in terms of its dependency on capital spending to generate growth. Although the transition from a high growth model dependent on investments to a slower growth model driven by consumption demand can be pushed slightly into the future (at the risk of causing a credit bust), it cannot be avoided.

Grasim/ UltraTech: Merger ratio of 0.57x; Grasim will own 60.3% in UltraTechThe boards of Grasim and UltraTech have approved the merger of their cement businesses. The shareholders of Samruddhi Cement (SCL), Grasim's demerged cement business would receive four shares of UltraTech (UTC) for every seven shares of SCL.Highlights of the restructuring

■ The merger ratio of 0.57x (UTC:SCL) values SCL at US$107/ton (at UTC's current market price of Rs729) as against UTC's current valuation of US$79/ton (pre-merger).■ The deal is marginally favorable to Grasim's minority shareholders, with economic interest in cement capacities going up from 29.1mt to 29.4mt.■ Post merger, Grasim will own 60.3% stake in UTC.■ The appointed date of the merger is 1 July 2010.

Both Grasim and UTC are attractively valued. Grasim trades at US$51/ton (~35% discount to UTC and 42% discount to ACC/Ambuja), at a significant discount compared to its historical average. Despite being the largest cement company in India and 10th largest in the world, UTC is trading at US$89/ton (~4.6x EV/EBITDA) - a 10% discount to replacement cost. We maintain Buy on both Grasim and UTC.

UltraTech: largest cement asset, with pan-India presencePost-merger of SCL, UTC would be the largest cement company in India, with 49.4mt capacity (including white cement) and the 10th largest in the world. Unlike pre-merger, when its market mix was concentrated in the West, East and South, it would become a pan-India player, with healthy contribution from all regions.

Grasim: majority ownership to restrict holding company discountPost restructuring, Grasim's standalone operations would be a pure-play on VSF and it would be a holding company for the cement business. It would be the third-largest VSF player in the world (AV Birla group is the largest player globally), with total capacity of334,000 tons. Grasim is investing Rs10b for setting up an 80,000-ton Greenfield VSF unit at Gujarat, which would take its total VSF capacity to 414,000 tons by FY13. Grasim (standalone) would have liquid investments of Rs22.7b and strategic investments valued at ~Rs21.6b in group companies.

Post announcement of restructuring plans, the Grasim stock has corrected by 18% and trades at an implied holding company discount of 35%, and 37-46% discount to ACC and Ambuja. Historically, it has traded at a median discount of 15% to ACC and Ambuja, and at a median premium of 10% to UTC. Unlike other holding companies that do not own majority stake of the operating company, Grasim would own 60.3% stake and would continue to control UTC. Hence, the current implied discount appears to be on the higher side. We maintain Buy, with an SOTP-based target price of Rs2,718. In our SOTP calculations, we have built in VSF at 4x EV/EBITDA, cement assets at US$80/ton (~20% discount to replacement cost), and embedded value of SCL shareholding (based on UTC's current market price).

Higher metal scrap imports by the Far East (China) from the US (largest scrap exporter) have reversed the trend of continuous scrap price decline in the past two months. Bunching out of deliveries (prior to New Year holidays) is indicting an increased Chinese propensity to produce. Also, direct orders from producers and affiliated trading companies point to ground-level demand accretion. Further, scrap at current levels is increasingly being considered as a substitute to iron ore. Helped by restocking demand in other regions of the Far East, we expect a hitherto weak US scrap market to firm up. With rebar-to-scrap spread at five-year average and strengthening export markets, a short-term inflationary cycle in steel price is likely. Though Indian prices for all products have got differentiated (higher) versus inventory-evacuation priced ‘distress-exports’ from the East, a positive scrap price trend will in turn lead to stocking intention, thereby propping prices. We maintain our positive stance on Steel Authority of India and Tata Steel.

■Chinese deep-sea scrap imports fetch higher prices. Price of #1 heavy melting scrap (HMS) has increased to US$308-315/te CIF (3-10% rise) for imports to China from the US. This is due to purchase of deep-sea cargoes in rapid succession between the final week of October and the first week of November, with most of the cargoes scheduled for December delivery. Chinese buyers have secured 14 cargoes (total quantity 450,000-500,000te). Concerned Chinese buyers represent major steelmakers for end users and their affiliated trading companies. Hence, deep-sea cargo imports stem from inquiries close to actual demand. Since arrivals might be one after the other in early CY10, negotiated scrap imports may be used to meet increased steel production before China’s lunar New Year holidays in CY10.

■China’s cumulative ferrous scrap imports hit an all-time high of 11.2mnte in January-September ’09, up 389.2% YoY. In September ’09, China’s ferrous scrap imports totalled 1.3mnte, up 4.7x YoY. Of the total, the US supplied the largest quantity of 499,000te followed by Japan at 353,000te (Table 1).

■Scrap increasingly substituting iron ore. China’s major steelmakers are considering imported ferrous scrap as a low-cost material given rising spot prices of iron ore imports. At present, spot prices are at ~US$100/te for Indian iron ore supplies to China, up ~10% from mid-September ’09 levels. So more impetus will be given on: i) accrued iron ore inventory on ports (wherein signs of destocking are visible), ii) increased domestic production of iron ore and iii) increased scrap imports to build a stockpile (as most cargoes are aimed for December delivery).

■Prices further propped by stock piling in South Korea where Public Procurement Service (PPS) held its tender in the fourth week of October ’09 to purchase a deep-sea cargo from the US for December delivery. PPS has secured 40,000te at US$312/te C&F for #1 HMS. PPS held its purchase tender this time under its policy to stockpile ferrous scrap, thereby stabilising the domestic market.

■ Scheduled December deliveries will help firm up weak US markets. A weak domestic scrap market in the US has been a concern. The composite price of US ferrous scrap fell by US$17.67 a week ago to US$207/te for #1 HMS as of November 9, when it came down for six consecutive weeks since the first week of October. The composite price of #1 HMS declined by a cumulative US$49.34 after it peaked at US$256/te in the second week of September. The composite price indicates the average of delivered prices for steelmakers in Pittsburgh, Chicago and Philadelphia. The scrap-rebar spread in the US is at normalised five-year average (Chart 2). Upward pressure on scrap price will invariably lead to steel price inflation.

• Back to growth: ICICI Bank, after a cautious approach to balance sheet growth for the last six quarters, is kicking back on the growth track. Loan sanctions have picked up especially in the infrastructure segment and management expects this to translate into robust loan growth over next 6-9 mnts. Also ICICI is getting back into the auto and home loan segments. Loan book contraction for the international book would also not be as severe as expected earlier but refinancing costs have not come off enough for the bank to look again at growing the international book aggressively. Overall loan book is expected to be flat for FY10 and grow in-line with the system credit in FY11.

• Margins to keep improving: Domestic margins are expected to improve to ~3.0% from 2.8% due to increasing CASA (maintain 33- 35% levels) and positive impact of deposit re-pricing though loan pricing would dilute some of the benefits. Margins for the international book are likely to stay ~0.5% in the near term but improve over the medium term (next 2-3 yrs) as re-financing costs come-off. Overall margins would continue to improve due to increasing domestic book mix and higher CASA margins.

Visibility improving, leverage to high growth - ALERT

• Worst over for asset quality: Delinquencies have likely peaked out in 1H10 and expected to be lower going forward. Management expects greater than Rs12bn of slippages per qtr. Provisioning could remain elevated for next 3-4 qtrs to comply with the RBI's 70% provisioning requirement.

• Capital more than adequate? Management expects ROAs to normalize to industry levels over the medium term but ROE normalisation would be gradual as natural leveraging up would taketime, and management is not very inclined to leverage up through higher payout or other measures of aggressive capital deployment.

• Fee income and costs: Management expects fee income growth to recover with credit growth and FY11 fee income could surprise with a higher than balance sheet growth. Operating costs have declined by ~15% in 1HFY10 but branch expansions and possible salary hikes could lead to nominal costs increases.

• Overall, ICICI is returning back to growth after a period of consolidation and we believe ICICI offers leverage to high growth with improving profitability and asset quality.

■September-09 traffic growth robust, third consecutive month of double digit growth: In September 2009, passenger traffic at Delhi airport grew by 21% YoY and for Mumbai airport at 15% YoY. For Hyderabad airport, the growth in passenger traffic stood at 15% YoY. For 2QFY10, passenger traffic at Mumbai airport grew by 10% YoY and 20% YoY for Delhi airport. The difference in growth rate is attributable to International passenger traffic, which grew by 4.8% YoY for Delhi airport, vs decline of 0.8% YoY at Mumbai airport for Sep-09. Key thing to note is that Delhi airport has been recording positive international traffic growth from last 5 months, vs de-growth at Mumbai airport over the same period.

■All-India August 2009 passenger traffic MoM run-rate improves, YoY growth driven by low base: In August 2009, total passenger traffic grew by 17% YoY to 9.8m, comprising of domestic passenger of 7m (up by 22% YoY) and international passenger traffic of 2.8m (up by 6% YoY). This represents second consecutive month of double digit growth, supported by the lower base effect, as passenger traffic reported first YoY decline in July 2008. However, there has been improvement in MoM run-rate. The average monthly run rate has improved from sub-9mpassengers/month to 9.5m+passenger/month.

■ ATMs grew by 6% YoY, Cargo growth at 8% YoY: In August 2009, total Air Traffic Movement (ATMs) stood at 111k up by 6% YoY vs passenger growth of 17% YoY. For Delhi airport, ATMs grew by 30%, vs 21% growth in passenger traffic; while for Mumbai airport ATMs de grew by 1.1%, vs passenger growth of 15%. Hyderabad airport witnessed 3.2% growth in ATMs, vs passenger traffic growth of 14%. All India air cargo traffic in August 2009 was up 8% YoY to 160k tons, comprising of 21% YoY increase in domestic cargo and 2% YoY increase in international cargo.